Initial Project Screening

Method - Payback Period

Lecture No.15
Chapter 5
Contemporary Engineering Economics
Copyright © 2006

Contemporary Engineering Economics, 4th

edition, © 2007
Example 5.1 Describing Project Cash Flows
Year Cash Inflows Cash Outflows Net
(n) (Benefits) (Costs) Cash Flows
0 0 $650,000 -$650,000
1 215,500 53,000 162,500
2 215,500 53,000 162,500
… … … …
8 215,500 53,000 162,500
 Payback Period
 Principle:
How fast can I recover my initial investment?
 Method:
Based on the cumulative cash flow (or accounting
profit)
 Screening Guideline:
If the payback period is less than or equal to some
specified payback period, the project would be
considered for further analysis.
 Weakness:
Does not consider the time value of money
Example 5.3 Payback Period
N Cash Flow Cum. Flow Payback period should
0 -$105,000+$20,000 -$85,000 occurs between N = 2
1 $35,000 -$50,000 and N = 3.
2 $45,000 -$5,000
3 $50,000 $45,000
4 $50,000 $95,000 3.2 years
5 $45,000 $140,000 Payback period
6 $35,000 $175,000

$45,000 $45,000
$35,000 $35,000
Annual cash flow

$25,000
$15,000
0
1 2 3 4 5 6
Years
Practice Problem
 How long does it take to recover the initial investment
for the computer process control system project in
Example 5.1?

Initial Cost
Payback Period =
Uniform annual benefit
$650,000

$162,500
 4 years
th
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Discounted Payback Period
 Principle:
How fast can I recover my initial investment
plus interest?
 Method:
Based on the cumulative discounted cash flow
 Screening Guideline:
If the discounted payback period (DPP) is less
than or equal to some specified payback period,
the project would be considered for further
analysis.
 Weakness:
Cash flows occurring after DPP are ignored
Contemporary Engineering Economics, 4th
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Discounted Payback Period Calculation
Period Cash Flow Cost of Funds Cumulative
(15%)* Cash Flow
0 -$85,000 0 -$85,000

1 15,000 -$85,000(0.15) = -$12,750 -82,750

2 25,000 -$82,750(0.15) = -12,413 -70,163

3 35,000 -$70,163(0.15) = -10,524 -45,687

4 45,000 -$45,687(0.15) =-6,853 -7,540

5 45,000 -$7,540(0.15) = -1,131 36,329

6 35,000 $36,329(0.15) = 5,449 76,778

* Cost of funds = (Unrecovered beginning balance) X (interest rate)

Contemporary Engineering Economics, 4th
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Summary

Payback periods can be used as a screening

tool for liquidity, but we need a measure of
investment worth for profitability.

Contemporary Engineering Economics, 4th

edition, © 2007
Discounted Cash Flow
Analysis

Lecture No.16
Chapter 5
Contemporary Engineering Economics
Copyright © 2006

Contemporary Engineering Economics, 4th

edition, © 2007
 Net Present Worth Measure
 Principle: Compute the equivalent net surplus at n = 0 for a given
interest rate of i.
 Decision Rule for Single Project Evaluation: Accept the project if the
net surplus is positive.
 Decision Rule for Comparing Multiple Alternatives: Select the
alternative with the largest net present worth.

Inflow
0 1
2 3 4 5

Outflow Net surplus

PW(i) inflow
0 PW(i) > 0
PW(i)outflow
Example 5.5 - Tiger Machine Tool Company

inflow
$24,400 $27,340 $55,760
0
1 2 3
outflow $75,000

PW (15%) inflow  $24,400( P / F ,15%,1)  $27,340( P / F ,15%,2)

$55,760( P / F ,15%,3)
 $78,553
PW (15%) outflow  $75,000
PW (15%)  $78,553  $75,000
 $3,553  0, Accept

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 Present Worth Amounts at Varying Interest Rates

i (%) PW(i) i(%) PW(i)

0 $32,500 20 -$3,412
2 27,743 22 -5,924
4 23,309 24 -8,296
6 19,169 26 -10,539
8 15,296 28 -12,662
10 11,670 30 -14,673
12 8,270 32 -16,580
14 5,077 34 -18,360
16 2,076 36 -20,110
17.45* 0 38 -21,745
18 -751 40 -23,302
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*Break even interest rate
Present Worth Profile

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Can you explain what $3,553 really means?
Project Balance Concept

 Suppose that the firm has no internal funds to

finance the project, so will borrow the entire
investment from a bank at an interest rate of 15%.
 Then, any proceeds from the project will be used
to pay off the bank loan.
 Then, our interest is to see if how much money
would be left over (surplus) at the end of the
project period.
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 Project Balance Concept
N 0 1 2 3
Beginning Balance -$75,000 -$61,850 -$43,788
Interest -$11,250 -$9,278 -$6,568
Payment -$75,000 +$24,400 +$27,340 +$55,760
Ending Balance -$75,000 -$61,850 -$43,788 +$5,404

PW(15%) = $5,404 (P/F, 15%, 3) = $3,553 Net surplus

Project Balance Diagram
Project balance ($)

Project surplus
20,000
0 $5,404
-20,000
-40,000
-$43,788
-60,000 -$75,000 -$61,850
-80,000
Discounted
-100,000 payback period
-120,000
0 1 2 3
Year(n)

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 What Factors Should the Company Consider in Selecting
a MARR in Project Evaluation?

 Cost of capital
 The required return necessary to
make an investment project
worthwhile.

premium
 Viewed as the rate of return that a

Risk
firm would receive if it invested its

MARR
money someplace else with a
similar risk

Cost of capital
 Risk premium
 The additional risk associated with
the project if you are dealing with a
project with higher risk

Contemporary Engineering Economics, 4th

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Practice Problem

 An electrical motor rated at 15HP needs to be

purchased for $1,000.
 The service life of the motor is known to be 10 years
with negligible salvage value.
 Its full load efficiency is 85%.
 The cost of energy is $0.08 per kwh.
 The intended use of the motor is 4,000 hours per
year.
 Find the total cost of owning and operating the
motor at 10% interest.

Contemporary Engineering Economics, 4th

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Solution
1HP=0.7457kW
15HP = 15  0.7457 = 11.1855kW
Required input power at 85% efficiency rating:
11.1855kW
 13.1594kW
0.85
Required total kWh per year
13.1594kW  4,000 hours/year =52,638 kWh/yr
Total annual energy cost to operate the motor
52,638kWh  $0.08/kWh =$4,211/yr
The total cost of owning and operating the motor
PW (10%)  $1, 000  $4, 211( P / A,10%,10)
= $26,875

0 1 2 3 4 5 6 7 8 9 10

$1,000
$4,211
Variations of Present Worth
Analysis

Lecture No.17
Chapter 5
Contemporary Engineering Economics
Copyright © 2006

Contemporary Engineering Economics, 4th

edition, © 2007
Future Worth Criterion
$55,760
 Given: Cash flows and MARR (i)
$24,400 $27,340
 Find: The net equivalent worth at a
specified period (future), 0 1 2 3
commonly the end of project life
$75,000
 Decision Rule: Accept the project if
the equivalent worth is positive.
Project life

FW (15%)inflow  $24,400( F / P,15%,2)  $27,340( F / P,15%,1)

$55,760( F / P,15%,0)
 $119,470
FW (15%)outflow  $75,000( F / P,15%,3)
 $114,066
FW (15%)  $119,470  $114,066
 $5,404  0, Accept
Example 5.7 Future Equivalent at an
Intermediate Time

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Example 5.9 Project’s Service Life is Long

• Built a hydroelectric plant using his personal savings of $800,000

• Power generating capacity of 6 million kwhs

• Estimated annual power sales after taxes $120,000

• Expected service life of 50 years

•
Was Bracewell's $800,000 investment a wise one?

•How long does he have to wait to recover his initial investment,

and will he ever make a profit?
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 Mr. Bracewell’s Hydroelectric Project
V1  V2  $1,101K  $1, 468K
 $367 K  0
V2  120 K ( P / A,8%,50)
 $1, 468K

V1  $50 K ( F / P,8%,9)  $50 K ( F / P,8%,8)

 $100 K ( F / P,8%,1)  60 K
 $1,101K
Comparing Mutually
Exclusive Alternatives

Lecture No.18
Chapter 5
Contemporary Engineering Economics
Copyright © 2006

Contemporary Engineering Economics, 4th

edition, © 2007
Comparing Mutually Exclusive Projects

 Mutually Exclusive Projects

 Alternative vs. Project

 Do-Nothing Alternative

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 Revenue Projects - Projects whose revenues
depend on the choice of alternatives

 Service Projects - Projects whose revenues do not

depend on the choice of alternative

 Analysis Period - The time span over which the

economic effects of an investment will be
evaluated (service life @ life span).

 Required Service Period - The time span over

which the service of an equipment (or investment)
will be needed.
 Comparing Mutually Exclusive Projects
 Principle: Projects must be compared over an equal lives
span.
 Rule of Thumb: If the required service period is given, the
analysis period should be the same as the required service
period.
Case 1: Analysis Period Equals Project Lives
Compute the PW for each project
$600 $2,075 $2,110
$450 $500 $1,400
0 0
1 2 3 1 2 3

$1,000 A $4,000 B
PW (10%)A = $283
PW (10%)B= $579 Select B
By outbidding its competitors, Larson Company (LC), a defense contractor has
received a contract worth RM 18,610,900 to build navy flight simulators for
Malaysian Maritime Enforcement Agency (MMEA). The contract is expected to be
completed in five years starting from this year (year 0). Hoping to establish itself
as a technology leader in the field, the management of LC felt that it was worth
outbidding its competitors by providing the lowest bid at RM 7,560,900.
The expected cash outflows required to produce these simulators are estimated
to be RM 2,000,000 now (year 0), RM 3,800,000 during the first year and RM
3,100,000 on the second year. Starting from year three onwards, the cash
outflows are expected to decrease by10 percent each year until end of the
project’s life.
As stipulated in the contract, MMEA will make five progressive payments to LC as
follows:
Year 1 2 3 4 5 Total
Cash inflows 4,850,00 4,020,00 3,640,000 3,241,000 2,859,900 18,610,900

You are(RM) 0
asked to prepare 0
some financial analysis to present to the top
management of LC. MARR for this contract is assumed at 12%. Required:
a. Show the net cash flows of this project over the period of five-years
b. Using Present Worth method, determine the economic worth of this contract.
c. Using Future Worth method, calculate the economic worth of this project.
a. Show the net cash flows of this project over the period of five-years
Year Cash inflow (RM) Cash outflow (RM) Net Cash flow (RM)
0 2,000,000 -2,000,000
1 4,850,000 3,800,000 1,050,000
2 4,020,000 3,100,000 920,000
3 3,640,000 2,790,000 850,000
4 3,241,000 2,511,000 730,000
5 2,859,900 2,259,900 600,000
Total 18,610,900 7,560,900

b. Using Present Worth method, determine the economic worth of this contract.

NPW12% = -2,000,000 + 1,050,000(P/F, 12%,1) + 920,000(P/F, 12%,1) +

850,000(P/F,12%,1) + 730,000(P/F, 12%,1)+ 600,000(P/F, 12%,1)
= (-2,000,000 + 937,545 + 733,424 + 605,030 + 463,915 + 340,440)
= RM 1,080,354

c. Using Future Worth method, calculate the economic worth of this project.

NFW 12% = RM1,080,354(F/P, 12%,5) = RM 1,903,907

Summary
 Present worth is an equivalence method of analysis in which
a project’s cash flows are discounted to a lump sum amount
at present time.
 The MARR or minimum attractive rate of return is the interest
rate at which a firm can always earn or borrow money.
 MARR is generally dictated by management and is the rate
at which NPW analysis should be conducted.
 Two measures of investment, the net future worth and the
capitalized equivalent worth, are variations to the NPW
criterion.

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 The term mutually exclusive means that, when one of several
alternatives that meet the same need is selected, the others will
be rejected.
 Revenue projects are those for which the income generated
depends on the choice of project.
 Service projects are those for which income remains the same,
regardless of which project is selected.
 The analysis period (study period) is the time span over which
the economic effects of an investment will be evaluated.
 The required service period is the time span over which the
service of an equipment (or investment) will be needed.
 The analysis period should chosen to cover the required service
period.
 When not specified by management or company policy, the
analysis period to use in a comparison of mutually exclusive
projects may be chosen by an individual analyst.

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